By: Tim Azizkhan
Accounting has been coined “the language of business.” So you would think that all business owners are fluent in accounting. However, one study found that 60% of small business owners aren’t confident in finance and accounting! That includes a basic understanding of the difference between cash basis and accrual methods of accounting. These methods can have huge implications on a business, and this blog will discuss how cash basis and accrual methods of accounting can affect businesses differently.
I know what you’re probably thinking: “A blog about accounting…Why would I ever want to read that?” Hear me out. Want to better measure the health of your business? Interested in the IRS staying off your back? Better yet, are you interested in sticking it to the IRS by saving money on taxes? If any or all of those things sound good, this blog is for you.
what are cash basis and accrual methods of accounting?
The main distinction between cash basis and accrual methods of accounting is timing. The cash basis method is based on the inflow and outflow of payments. Businesses recognize revenue when payments are received and recognize expenses when payments are made. The accrual method, on the other hand, is based on obligations instead of payment. Businesses recognize revenue when a performance obligation is satisfied and recognize expenses as they are incurred.
Each accounting method also affects a business’s taxes. Each method determines the timing for when income and deductions are included in a business’s tax return. Income is generated under cash basis when a business actually or constructively receives payment. Deductions can then be taken when expenses are paid for. Yet income is recognized under the accrual method when income is simply earned. Deductions can then be taken when expenses are incurred.
How do i choose and change accounting methods?
The IRS provides business owners with wide discretion in choosing their preferred methods of accounting. Businesses can generally use either cash basis or accrual methods of accounting. However, the primary exception would be corporations and partnerships that do not meet the gross receipts test. The gross receipts test is conducted by adding a business’s gross receipts for the previous three tax years and dividing the sum of that number by three. If the resulting number is over $29,000,000, that business is barred from using the cash basis method of accounting. It must then use the accrual method. Businesses that previously qualified for cash basis use, but then outgrow the gross receipts test, are subsequently required to switch to the accrual method of accounting.
It may surprise business owners to know that, from the IRS’s perspective, they have already chosen their business’s method of accounting. A method is officially chosen the first year that the taxpayer business reflects the item on its tax return. Following that first tax return, a taxpayer business must consistently use that same method to clearly reflect income. Yet despite enjoying almost full discretion in choosing a method, the choice to change methods of accounting is subject to the approval of the IRS Commissioner.
The application to change accounting methods is called a Form 3115, which must be downloaded, completed, and sent to the IRS. Businesses hoping to change accounting methods should gather all financial statements, tax returns, and accounting records before filling out a Form 3115. It is vital that businesses include complete and accurate information for such applications. Businesses can typically expect a 30-day turnaround for the IRS to grant approval or deny an application. If granted, the taxpayer business may change its accounting method.
Are there advantages and disadvantages to using each accounting method for my business?
There are many factors that businesses should consider when choosing between the cash basis and accrual methods. These factors can be advantageous or disadvantageous depending on a business’s size, maturity, operations, goods or service offerings, and much more. This section will highlight three main factors that businesses should consider, at minimum, when it comes to accounting methods.
Factor 1: Simplicity
The cash basis method is much simpler than the accrual method. Small businesses often have owners that wear multiple hats, including that of an accountant. The cash basis method provides owners without an accounting background a simple and quick solution. They will also avoid the higher costs of accrual method accounting, which requires more backchecking and adjustments. Larger businesses can often absorb these costs and favor the accrual method for its complexity. The complexity allows businesses to have a more accurate measure of it health.
Factor 2: Measurability
The cash basis method measures a business’s cash flow extremely well. Businesses using this method can quickly and strategically analyze when and if liabilities can be paid. Alternatively, a business may seek a more accurate representation of its profitability. That’s where the accrual method shines. The accrual method encompasses accrued revenues and expenses that would otherwise be omitted by the cash basis method. Larger and mature businesses may favor this representation when answering to shareholders and creditors.
Factor 3: Timing
Timing is key for taxes. Businesses may prefer to limit taxes by pairing corresponding income and deductions in the same taxable year. The deductions help offset the amount of income tax a business will pay. The accrual method would be most beneficial for this purpose, as the reporting of income is not dependent on actual payment, and deductions are taken when incurred. The cash basis method, on the other hand, makes pairing income and deductions harder, because the taxpayer business must rely on another party’s timing of payment.
The accounting method your business uses matters!
Let me repeat: The accounting method your business uses matters! Accounting may not be the most exciting part of your business journey, but it sure is an important one. No matter what stage your business is in, take a few minutes to consider what accounting method is right for your business. Your business, and your bank account, might just thank you for it!
This post has been reproduced and updated with the author’s permission. It was originally authored on February 7, 2024 and can be found here.
Tim Azizkhan, at the time of this post, is a third-year J.D./M.B.A. candidate at Penn State Dickinson Law. He is from Mechanicsburg, PA and is a proud graduate of Gettysburg College. Tim is a research assistant for Professor Prince and the president of the Business Law Society. He aspires to open his own business.
Sources:
Forbes: Cash vs Accrual Accounting: What’s the Difference?
IRS: Accounting Periods and Methods
Fincent: How to Change Accounting Methods Using IRS Form 3115
Investopedia: Accural Accounting vs. Cash Basis Accounting: What’s the Difference?
National Business Capital: 36 Small Business Statistics You Need to Know (2020)
Source Advisors: Form 3115 Image
Vecteezy: Profit Growing Image
